The long slide of the stock market late in 2018 along with the burst balloon effect among the tech giants makes fixed income burn brightly as an investment vehicle. Investment aficionados know that bonds are a world unto themselves. The expectations and rewards differ significantly from stocks. Within fixed income, many seek the security of treasury bonds. The more venturesome look for the higher, steady return of unrated bonds. In between, one finds municipal debt, slightly more rewarding than treasury bonds but carrying more risk. The main focus of this series will be US municipals, excluding US territories, the euro zone, Japan and elsewhere.
Municipal bonds – state and local bonds issued in the US – are most rewarding because of their dependability. Worriers remember the WPPSS bonds (Washington Public Power Supply System) of yesteryear. It is unlikely that such a spectacular flop will happen again anytime soon. In fact, market watchers – sometimes synonymous with Warren Buffet watchers – know that while WPPSS involved huge nuclear plants, small nuclear utilities remain fairly attractive. Small plants carry much lower risk of mishaps. Other worriers look at Illinois, the least attractive bond issuer of the fifty states. Despite the risk, the point spread above standard – about 160 basis points on some projects – provides a fair return for the added risk. Defaults, which make insomniacs of some, remain rare.
Vast Scope of Infrastructure Projects
Typical municipal bond financing projects include roads, bridges, infrastructure, schools, transportation, water supply, public housing and other large public projects. All such projects connect with taxes. The large states – in area or population – provide the bigger investment opportunities. According to SIFMA, California issued over $69 billion of bonds in 2018, New York over $54 billion, Texas $40 billion, Florida $13 billion, which reveals a wide spread in the numbers among these large population states. (That is worth investigating in another article.) Among the massive individual projects in 2018, New York issued $260 million New York State Housing Finance Agency Affordable Housing Revenue Bonds; Chicago’s O’Hare reconstruction issue reached $1.8 billion; the Delaware River Port Authority in Pennsylvania generated $714 million. Some of these massive projects span federal, state and local funding and different coupon rates.
The huge O’Hare Airport project, for example, combines expansion and renovation. All told, more than 3.1 million square feet of new terminals will be built — a 72 percent increase over the current 4.3 million square feet. This extremely busy airport will also get major renovation. As a rule, steady, long-term infrastructure spending for new construction and repair outperforms waiting for public services to break down.
Solid opportunity for project success is critical. It is difficult to get a clear picture of which states have the greatest need for new infrastructure or infrastructure repair. New infrastructure excites everyone. The federal government and investors love the idea. Repairs bore everyone. Investors would like to see a project built and then move on to the next project. Wear and tear intrude. Key factors include the severity of winter weather – not just cold winters, but the state’s typical snowfall and days below freezing — as well as rapid population growth. Weather and traffic play major roles in damage to roads and infrastructure. A new road will likely draw federal attention. An existing road beaten up by cold winters and expanding population will more likely have to depend on local (municipal) funding for repair. According to infoplease, Texas has the most road miles, 303,000 as of several years ago.
Population growth is a major factor. Idaho, Nevada and Utah, for example, are growing rapidly according to the Census Bureau. Investors looking for opportunity will take note that these are sizeable states in land area if not population. Rapid growth means the state needs roads, schools and other infrastructure. Lack of needed resources such as water demands big infrastructure projects as well. The southwest has borne rapid population growth for some time and suffers from limited water supply. Apart from California, with the largest state population, Texas, Oklahoma, Arizona, and New Mexico are running short of drinking water.
On the other end of the scale, the upper Midwest has been losing population for some time, which suggests that they have less need of new infrastructure. However, severe winters require frequent maintenance of roads and other projects. Maintenance can run from patching a crack to rebuilding the entire roadbed. Some roads have a long and deep history. New York City, for example, has many trolley tracks underneath current road surfaces; so, depth can be taken literally. Heavy snow followed by rising temperatures that melt the snow followed by freezing at night wreak havoc across much of the country. Washington officials do not find these repairs appealing. While a rising population might generate a revenue stream to cover the cost, the upper Midwest is weighed down by more potholes and less revenue.
This myth is allowing us to look inside the promise and the reality of fixed income. The starting point on our municipal journey is to consider the scope of projects involved. Future entries will delve into the level of risk and the proper place of these bonds in a balanced portfolio.
The title of this series is a baseball expression that refers to a batter expecting a fast pitch but getting a slower pitch – and probably swinging too early. Those who demand high, rapid return (fast balls) may miss out on modest, steady, long term wealth creation (curve balls, which are slower). This first entry of the series reveals that municipal bonds are a world unto themselves. Yields rise and fall differently from stocks and while generally seen as lacking the happy spurts of the stock market, they can perform very handily. The next installment will delve into additional insights into this thriving block of every strong investment portfolio.
Michael McTague, Ph.D. is Executive Vice President at Able Global Partners in New York, a private equity firm.